August 30, 2012

Fiscal Rules and Councils: Most Effective When Used Together

Adopting numerical fiscal rules has been an integral part of the policy response to the medium-term fiscal consolidation challenge posed by the global financial crisis. According to Schaechter et. al. (2012), since 2009, at least 16 countries have adopted new national fiscal rules and many others are in the pipeline. The crisis has also revealed the need for reforming supranational rules, such as the Stability and Growth Pact of the EU and as a result new structural budget balance rules will be adopted in almost all of the EU member states as part of the “fiscal compact.” A recent paper by Charles Wyplosz titled “Fiscal Rules: Theoretical Issues and Historical Experiences,” is a timely review of the theoretical underpinnings of fiscal indiscipline and how numerical fiscal rules can help. Wyplosz argues that fiscal rules are neither necessary nor sufficient to achieve fiscal discipline; but that thoughtfully designed fiscal rules can be effective when supplemented with fiscal institutions (and in particular fiscal councils) that are tailored to the political institutions of the country.[2]

The paper first looks at the theoretical underpinnings of fiscal indiscipline, known as the “common pool problem”. The common pool problem arises when the beneficiaries of public spending or tax policies do not take into account the externalities that these policies impose on other groups (within a population, across different generations, among different levels of government or different states within a monetary union). Fiscal rules can in principle reduce these externalities by imposing explicit principles for fiscal behavior and thereby lowering the scope for deficit bias. According to Wyplosz, there are two key challenges: 1) fiscal rules cannot be fully contingent and hence they are subject to the “time-inconsistency problem” and 2) fiscal rules cannot be fully binding since they can be manipulated, changed or simply ignored. He argues that fiscal institutions (in particular, fiscal councils or other arrangements that give authority to an independent body to interpret rules) can help overcome these challenges.

The time-inconsistency problem implies that a numerical fiscal rule that is optimal under current circumstances may no longer be optimal in the future. Although fiscal rules can incorporate escape clauses, they cannot be completely contingent. If they were, they would have to be too complex to communicate to the public or to be understood by policymakers.[3] Furthermore, unforeseen events can lead to pressures to violate or suspend them. This has indeed been true for many European countries that were part of the Stability and Growth Pact. Wyplosz (2012) reports that the 12 initial member countries have satisfied the 3 percent budget deficit limit only 60 percent of the time. An area where the time inconsistency would certainly bind is if rules do not prescribe counter-cyclical fiscal policies. In particular, if rules do not create sufficient fiscal space during upturns, they will certainly be violated during downturns as experienced in many countries during the global financial crisis of 2008. In response to that, the new generation rules that are being adopted in many countries typically have some form of adjustment for the economic cycle.[4]

A second problem with fiscal rules is the fact that they can be manipulated. Budgets are forward looking by nature and this gives space to the government to loosen the rule. Ex-post evaluations of outcomes can help but it involves judgment and evaluations can come late. One way of overcoming this problem is through a “debt brake” rule as adopted in Switzerland and Germany. Rules can also be changed or simply ignored. For instance, politicians can convince the public that it is in their best interest to circumvent the rule. It is therefore important to ensure that there are credible sanctions if the rule is violated but that means the sanctions should be written in law and stipulated in a precise manner which would reduce the simplicity and the transparency of the rule.

The idea that fiscal rules and institutions (mainly fiscal councils) can complement each other is intuitively appealing. Fiscal rules are too rigid to be credibly enforceable whereas fiscal institutions can be too open-ended and not sufficient to guide fiscal policy. In particular, fiscal institutions can help with the time inconsistency problem by providing guidance in applying numerical fiscal rules. For instance, fiscal councils that interpret not fully contingent rules could be a promising way to approach the design of fiscal rules and institutions. Fiscal institutions could also help ensure that rules are not easily manipulated, ignored or changed. Wyplosz provides a nice discussion of how this complementarity has worked in Netherlands and Chile and more recently in the UK.

In all three countries, an independent fiscal authority is given authority to provide independent economic and budget forecasts. In Netherlands, the fiscal rule proposes a path for the budget ceiling that is negotiated by the coalition parties and reset with every new parliament. According to Wyplosz, the fiscal rule in Netherlands has worked not only because it combines rules and institutions but also because the fiscal rule is formulated as the outcome of a political contract formed by the multi-party coalition governments that have characterized the Dutch political system. In Chile, the numerical fiscal rule prescribes a certain structural budget balance and a committee of independent experts determines structural revenues based on their assessment of output and copper price developments. Although the rule has no escape clauses, the target can be changed, as it has been during the global financial crisis. The Chilean fiscal rule is in that sense somewhat flexible but is also “incomplete” as the circumstances that could justify changing the rule are not specified, nor are there sanctions for deviating from the rule. The consensus view is that Chile’s fiscal rule has worked quite well and Wyplosz argues that this is due to the existence of a fiscal council of experts that provides an independent and transparent interpretation of the fiscal rule. However, he also acknowledges that the delegation of power to the President on setting the budget has also been important in the success of the fiscal rule and highlights the role of political institutions in the effectiveness of fiscal rules. In the UK, the newly established Office for Budget Responsibility (OBI) is given the sole responsibility for the forecasts of macroeconomic variables and budget indicators and will therefore play an important role in implementing the UK’s new fiscal rule which is based on five-year forecasts of the structural fiscal balance. Going forward, it will be interesting to observe how the OBI and many other newly established fiscal councils will help support the success and implementation of fiscal rules.[5]

Finding good examples of arrangements that have worked within monetary unions is more challenging. Wyplosz discusses how in the Euro area, institutions and fiscal rules prior to the crisis have not been effective in achieving fiscal responsibility. According to Wyplosz, this was due to the weaknesses in the design of the Stability and Growth Pact, which has not been supported by hard, domestic legislation and has implied pro-cyclical, time-inconsistent fiscal policies. The lack of an independent body that is responsible for monitoring member countries’ fiscal plans and the implementation of fiscal rules is identified as another weakness. The new set of fiscal rules and institutions that are being adopted in the Euro area under the “fiscal compact” and the adoption of the European semester which is a commitment by member countries to submit their economic and budget plans to the European Commission to enhance policy coordination within the EU are steps towards fixing some of these shortcomings. The main insight from Wyplosz’s paper that fiscal rules can be more effective when combined with appropriately designed fiscal institutions could guide the effective design of supra-national fiscal rules and institutions in monetary unions. However, as Wyplosz argues, fiscal rules and institutions need to be well adapted to the political institutions of individual countries and this could be one of the main challenges for supra-national rules and institutions with a multitude of political arrangements.

Schaechter, Andrea, Tidiane Kinda, Nina Budina and Anke Weber (2012), “Fiscal Rules in Response to the Crisis—Toward the “Next-Generation” Rules. A New Dataset,” IMF Working Paper/12/187.

[1] Elif C. Arbatli is an economist at the Fiscal Affairs Department of IMF.

[2] In Wyplosz (2012), fiscal rules are defined specifically to cover rules that impose numerical norms on budget balance, public spending or government revenues. They are therefore distinguished from fiscal institutions which entail formal procedures governing the budgetary process that do not rely on quantitative restrictions. Examples of fiscal institutions include delegating parts of the budget process to an independent body such as a fiscal council, intra-governmental agreements and multi-year fiscal programs.

[3] In fact the use of formal escape provisions is still relatively rare. (Schaechter et. al. 2012)

[4] See Schaechter et. al. (2012) for a detailed discussion of structural budget balance rules. A key complication in applying such rules is how the structural balance should be defined and measured.

[5] Other countries that have recently established fiscal councils include Ireland, Portugal, Serbia, Sweden and Romania.

Note: The posts on the IMF PFM Blog should not be reported as representing the views of the IMF. The views expressed are those of the authors and do not necessarily represent those of the IMF or IMF policy.